The Key to Income Riders

Income riders were first introduced on variable annuities as a way of providing a guaranteed income off of an asset that was subject to market ups and downs. The idea was to insure that even if poor investment performance and income withdrawals reduced the value of the variable annuity to zero, the owner or annuitant would still have income for their lifetime or until they got back all of their original investment.

This revolutionized the variable annuity industry and was, in many ways, a return to the original purpose of annuities, which was to provide guaranteed income solutions. These riders are called different names by different companies but are typically known as Guaranteed Minimum Income Benefit (GMIB) riders and Guaranteed Minimum Withdrawal Benefit (GMWB) riders.

Rather than going into the intricacies of these riders, a simple example showing how they work in general will provide a better understanding. Here is the basic idea: Make a deposit into a variable annuity. At some point, start taking a set withdrawal amount of typically around 5% or 6% of the value of the annuity (this is set by the issuing company). If the annuity grows by enough to offset the withdrawals, then upon the death of the annuitant or owner, the beneficiary will receive the money still in the annuity, which may be more than the original investment. This is the plan and works well in good markets and the income rider never really “kicks in”. But what if the investments in the variable annuity perform poorly due to bad markets? If the variable annuity doesn’t grow by enough to cover the withdrawals and they eat up all the value, then the income rider comes into play. The rider guarantees that in this event, the same amount of money the owner has been withdrawing will continue coming to them for their lifetime and some will even continue this income for the life of a spouse.

The overall concept is that you are insuring your investment income and letting the insurance company bare the risk of poor performance and bad markets. These riders eventually started appearing on index annuities as well. They became very popular as they provided a way to draw a steady amount of income from a product that didn’t generate a fixed amount of interest every year. Remember, due to the way index interest works, in good market years the index annuity can earn double digit returns but in bad market years it earns 0% (which is still better than a loss). Income riders became a way of stabilizing the interest income from an index annuity and allowing the good years to average out the zero years. What happens if we have a protracted bear market?

If this occurs, then even though the index annuity doesn’t take any market losses, steady income withdrawals can still eat up the value. In this case, the income rider works the same way as it would on the variable annuity, guaranteeing lifetime income for the owner and possibly for their spouse as well.

As with the variable annuity, the income rider is meant to guarantee the income off of an investment in case markets prove uncooperative. Annuity companies actually went one step further with income and withdrawal riders by building a guaranteed income growth account value into them.

Realizing that many annuity investors wouldn’t want to start drawing income right away, the riders were modified to allow a “roll up” to the amount of income the rider would guarantee until the investor started taking it. This change allowed the annuity investor to be guaranteed a certain amount of income to start at a future time and for that income to be guaranteed for life. It in essence allowed someone to buy their own retirement pension, but with the added benefit then a substantial lump sum could still be passed on to a beneficiary.

As this may sound confusing, let’s look at an example to make this a bit clearer. Let’s assume an investor puts $100,000 into an index annuity with an income rider that rolls up the income value at 7% per year and allows guaranteed lifetime withdrawals of 5% of the income account value when started. Column 1 shows the year, column 2 shows the actual return of index interest for that year, column 3 shows the actual cash accumulation value of the index annuity, column 4 shows the income account calculation value and column 5 shows the guaranteed lifetime annual income amount if started that year.

In this example, if an investor wanted to start taking income in year 7, they would begin drawing $8,029 per year which would be deducted from their cash account value or actual cash value. The income account roll up would stop at this point and the investor would be guaranteed by the insurance company to draw $8,029 for life. The cash value account would still be earning index interest depending on the year-to-year performance of the underlying index. In some years, this may be enough to cover the amount of the withdrawal, but in others it may not.

If the owner draws this income for only a few years and then dies, whatever amount is still in the cash account value would go to their beneficiaries. Depending on the index interest performance during those years, this could become more or less than their starting value of $136,847.

If the markets were bad for many years causing index interest to perform poorly, the withdrawals could use up all of the $136,847. If this happens, the owner has still gotten out all that they put in, plus all that it earned during the first 7 years. However, at this point, the rider would takeover and would keep the $8,029 coming in every year for the rest of the owner’s life (and possibly their spouse’s life if the withdrawal was set up jointly). The amount of the income rider roll up and the withdrawal percentages will vary from company to company, but that is the overall concept. In total, the riders offer a good way to draw reliable income off of an asset with varying returns.

It should be noted that there is usually a charge to have these income riders added onto either a variable annuity or an index annuity. This is typically an internal fee that is deducted from the cash account value or from the index interest performance. However, some index annuities have a base income rider built into them for which there is no charge, and then they offer an upgrade to one with higher roll up values for an additional cost.

J.R. Thacker
J.R. Thacker is President and Founder of Thacker & Associates Inc. and President of Center Street Securities, Inc. He has worked in the financial services industry since 1996. Thacker founded his own firm specializing in retirement planning. His unique approach to retirement investing quickly became popular, and the firm was voted “Best Financial Planner” for six years in a row. He can be reached by e-mail at info@indexinterest.com or jrthacker@thackerandassociates.com.